Lest We Forget:
The Asian Financial Crisis & the
Need for Greater Regional Cooperation
Written for the MAS-ESS Essay Competition 2006-07
By Geoffrey (Kok Heng), See
施国兴 . 시곡행
WhartonSchool (University of Pennsylvania)
Huntsman Program in International Studies and Business
Abstract
Ten years after the Asian Financial Crisis, growth and portfolio flows have returned to Asia. The image of the tiger economies of Asia, reformed and economically vibrant again, is alluring, while the Crisis seemed like a nightmare that went just as quickly as it came. Unfortunately, reality is more nuanced. While financial and corporate reforms have taken place, we still have essential steps left to take to ensure economic security for the region. These steps include measures to minimize the short-term damage of future crises, and measures allowing us to better resolve these crises. However, these last steps are also the hardest because they require regional cooperation to implement. In pursuing these steps, we need the Asian Financial Crisis asa reminder of the devastating outcomes for individuals when our economic and political systems fail its people, and as the impetus encouraging us to act.
Lest We Forget
I was twelve in the summer of 1997, when the Asian Financial Crisis buffeted Singapore’s shore. I knew something momentous had happened in Asia then, but did not understand what it was. My main recollections from that period were of my parents telling me in hushed tones that my pocket money had to be reduced, and of my father’s friend from Thailand, Pasarn, who stopped visiting us. Pasarn owned several hotels in Thailand, and visited my family frequently before 1997. He would always hand me a fifty dollar bill away from my parent’s watchful eyes before he left Singapore. Iconsidered it a fortune back then. Then Pasarn stopped coming, and I did not know why.
When I grew up, I found out that Pasarn had committed suicide shortly after the crisis. His wealth disintegrated with the collapse of Thailand’s real estate market. I imagined this must be the life story of many individuals who lived through the crisis in the hardest hit places. Pasarn inspired my interest in economics and the Asian Financial Crisis, and I hope that we can keep him in mind as we examine the macroeconomic causes and consequences of the Crisis. His story is the story of Asians during the trauma of the Crisis. It is a reminder of the devastating outcomes for individuals when our economic and political systems fail its people.
The Ghost of Crisis Present
Ten years later, I am sitting in the WhartonSchool listening to Professor Nicholas Souleles tap his trademark metallic pointer across data from the emerging markets of Asia. 2006 was an amazing year, with growth in all the Asian economies. It looks as if Asia and the world had left the Crisis behind. Private capital flows to emerging economies including Asia peaked at US$212.1 billion in 1996, fell for three years to US$66.7 billion in 1999, before finally rising to US$145.4 billion in 2000.[1] Dissecting private capital flows revealed that the largest increases in inflows into emerging markets from 1999 to 2000 were in portfolio flows. Equity markets seemed to believe that the boom times are back.
Similarly, the current account deficit of the pre-Crisis years disappeared! Deficits have given way to massive foreign reserve surpluses, and sudden massive capital outflows seem a thing of the past. Financial sector reforms have also been pursued, with largely effective steps taken across Asia to close down insolvent banks and clear out non-performing loans (fig 1.0 illustrates this using Thailand as an example).
The image of the tiger economies of Asia, reformed and economically vibrantagain, is alluring. The Crisis seemed like a nightmare that went just as quickly as it came, thefinancial chills it sent down Asia’s economic spine readily forgotten. Unfortunately, reality is more nuanced. VisitingSeoul, Taipei, Bangkok and Singapore, I realized that the trauma of the crisis lingers on in these tiger economies. In Taipei, I discussed the future with friends who just started working and friends who just graduated. They faced depressed wages and uncertain job opportunities,even though many of them were the academic elite ofNationalTaiwanUniversity. Many of them looked with envy across the Taiwanstraits to booming China, and wonder if that is where their future lies. In Seoul, my friend treated me to a meal at a posh restaurant in fancy Apkujeong district. Her father worked at the Bank of Korea as a central banker, a job symbolizing prestige of security. She planned to study in the United States for graduate school then immigrate there - with the encouragement of her father. She feared for South Korea’s economic prospects: rising inflation, the recessions of the Asian Financial Crisis in 1997, and the Credit Meltdown in 2004[2] dampened her optimism. In Singapore, the government sought new economic strategies through a high-profile Economic Review Committee in 2001.[3]
Such pessimism definitely fails to represent the perspectives of everyone in the tiger economies of South Korea, Taiwan, Singapore or Hong Kong. However, they symbolize the lives the Crisis touched, and how the Crisis permanently shatteredAsia’sconfidence inboundless economic progress, and replaced it with a future of greater uncertainty, insecurity and economic soul-seeking. In Bangkok, a half-built skyscraper, its walls covered with graffiti, is juxtaposed against the fancy neighboring Landmark Hotel in upscale Sukhumvit Road, serving as a poignant reminder of the heady days of the Asian Financial Crisis. Lest we forget, we need take a trip to the past to uncover what happened during the crisis, why it happened, and howAsia changed. Most importantly, we must understand what Asia has left to do in order to prevent something as terrible from happening again.
The Ghost of Crisis Past
In 1997, economies across Asia, including Singapore, Thailand, Malaysia, Philippines, Taiwan, South Korea, Indonesia and Hong Kong were engulfed in the storm called the Asian Financial Crisis. Thailand was the epicenter of this storm. In the years leading to the crisis, Thailand’s current account deficit widen dramatically.[4] It’s tightening of monetary and fiscal policies, combined with a pegged exchange rate and relatively open capital account resulted in massive short-term capital inflows – the mixed blessing of “hot money.” These flows were intermediated by commercial banks, resulting in Thai banks borrowing heavily in foreign currencies at very short maturities to fund questionable investments.[5]
These macroeconomic imbalances placed pressure on the Thai baht to devalue. In 1996, slowing export growth exacerbated this situation. Thailand came under four speculative attacks on the baht, and in September, Moody downgraded Thailand’s short-term sovereign ratings.[6]The Bank of Thailand drew on its foreign reserves to defend the baht, and supported financial institutions initially out national accounts, before suspending 16 finance companies receiving excessive amounts of foreign credit.[7] The defense did not last, interest rates rose 20 percent in late June, and the currency finally succumbed on July 2 as the Thai peg collapsed into a float, with the Thai baht subsequently appreciating.[8]
As the Thai financial and economic system collapsed, reverberations were felt across Asia through two transmission mechanisms: trade and financial flows. The two transmission mechanisms pulled other countries into the storm, at different rates, creating several rounds of shocks for Asian and international economies. The first round of shocks was felt most keenly by neighboring economies at the same development stage. Indonesia, Malaysia and the Philippines all saw their currency and equity markets decline. Indonesia’s rupiah came under pressure as it faced increasing challenges in repaying its short-term external debt, finally leading to a lowering of interest rates and an appreciating exchange rate. This eventually led to the collapse of the Suharto regime in Indonesia, with political stability returning only several years later. By October 1997, exchange rates hadfallen by 51 percent in Indonesia, 34 percent in Malaysia, 32 percent in the Philippines, and 60 percent in Thailand.[9]
The violent assault on currencies in those Asian countries encouraged Taiwan and Singapore to devalue instead of draining their foreign reserves in a futile effort to stem the decline of their currencies.Hong Kong’s currency board also came under speculative attacks. South Korea valiantly and publicly declared its intention of defending the won and cleaning up its financial sector. How galling it must be to the Korean kukhwe (congress) when they failed to pass a bill to clean up insolvent Korean banks!Korea eventually abandoned its costly defense of the won, and negotiated an IMF bailout in November.[10]
The shocks from the initial Thai devaluation jolted the region, and set off a chain reaction with a life of its own. As more and more Asian economies suffered shocks and devalued, their weakened economies further fed the pre-existing financial turmoil in their neighbors from whom the crisis originated, which in turn rebounded back onto their economies. It was a downward spiral lasting several months - an eternity for financial markets. In early 1998, all the Asian countries, with the exception of Indonesia, appeared to stabilize. However, the heady days of irrational exuberance and relentless economic growth had disappeared with the dissipating storm.[11]
Cooking Up the Perfect Storm
How did the “Asian miracle” fell apart so rapidly? The decades of growth that preceded the Crisis were definitely real, with massive improvements on the economic wellbeing of the entire region. At the same time, this growth was built on a flimsy foundation hiding significant downside risks. An event of such epic proportions, with such devastating consequences, cannot be decomposed to a single cause, and we need to examine the range of explanations that in congregation created this perfect storm. Broadly, these explanations can be categorized into exogenous causes (it is not our fault!), and endogenous causes (we built our economies on a house of cards).[12]
In May 2006, I was presenting my non-profit work at the World Bank’s Annual Bank Conference on Development Economics in Tokyo. At the conference, I met a champion of the camp proposing exogenous causes as the primary reason for the Crisis. Nobel Prize winner Joseph Stiglitz was a keynote speaker, a curious oddity at a Bretton Woods Institution event.[13]During the highlight of the conference, the lunchtime buffet spread, I managed to talk to Joseph Stiglitz about the East Asian crisis. He could not resist taking a jab at his nemesis, the IMF, and further argued that “the East Asian crisis did not have to happen.”[14]
Joseph Stiglitz suggests that “[the Crisis] most important determinants are not found in its macroeconomic aggregates.”[15] While there were fundamental weaknesses in Asian economies, none of this factors suggests that the Crisis was “inevitable”. Instead, the speed at which financial markets turned against the Asian economies is analogous to a bank-run.[16] In this model, investors reversed their expectations of Asian market overnight, even though they faced the same market fundamentals as before, sparking a panicked and self-fulfilling collapse of the economy.[17] In developing markets, where investors cope not only with imperfect information on market situations, but also with imperfect information on the bounds of their rationality,[18] it is unsurprising that aswing in opinion can happen. As markets turn, investors might realize that they do not know as much about the markets as they previously think they did, sparking further withdrawals from Asian economies, which in turn cascades into even greater uncertainty.
Three exogenous events also added depth to the Crisis. The Crisis arrived just as Japan was having a major recession within its decade-long recession. As a major importer, Japan’s slowdown had a two-fold impact of weakening demand for Asian goods, while worsening the current account deficit situation in the rest of Asia. The Crisis also occurred when China was just taking off as a cheaper competition to the rest of Asia in manufacturing, pressuring the current accounts of its neighbors. Lastly, United Stateswas in the midst of its technology bubble, generating seemingly high returns that reversed portfolio flows towards emerging Asia. However, calling these primary causes would be a stretch, as they do not account for the ferocity and velocity of the Crisis.
That there were exogenous causes should not distract from the underlying weaknesses in the Asian financial sector. If the World Bank and IMF had Financial Sector Assessment Plans back then,[19] they would have been horrified by the lending practices taking place all over Asia. Domestic financial institutions in many Asian countries were unready for the influx of capital that financial liberalization brought, as they lack proper prudential supervision, or had lending practices that conformed to politics more than to market forces. In South Korea, banks lend to chaebols to repay other banks, an ever-greening of loans described as “lending to Peter to pay Peter”.[20]Part of this unsustainable lending stemmed from moral hazard, as domestic banks assumed the government would share the downside risks of chaeboldebt defaults, while the banks themselves would reap the upside returns.[21]In Indonesia, the influx of foreign capital was directed by domestic financial intermediaries towards politically connected firms, while in Thailand capital inflows financed a real estate bubble. Much borrowing was carried out in foreign currency, exposing the financial system to huge currency risks. Internally, the financing of questionable investments made long-term repayment by banks and the over-leveraged corporate sector uncertain.
Pre-Crisis, some signs already pointed to an inefficient use of increased lending.Investment was heavily concentrated in sectors that exhibited excess capacity, such as in the real estate sector. The incremental capital-output ratio (ICOR) measures the inefficiency of investment crudely, and increased across all countries except Indonesia (see Table 1.0). Non-performing loans (NPLs) ratios for these countries were high. NPL ratios were alarming but not intimidating. More frightening was how the credit boom was accompanied by a more than commensurate increase in financial fragility. Unlike China, most of these economies had liberalized capital accounts, and increased their lending through borrowing in foreign currency overseas. High-priced property was also used as collateral in the increased bank lending.
Table 1.0: Pre-Crisis Indicators.Indonesia / Korea / Malaysia / Philippines / Thailand
Incremental capital-output ratio (ICOR)
1987-92 / 4 / 4 / 4 / 6 / 3
1993-96 / 4 / 5 / 5 / 6 / 5
Non-performing loans (NPLs)
Pre-crisis estimates: 1996 Official / 8.8 / 0.8 / 3.9 / na / 7.7
Pre-crisis estimates: Alternate / 12.9 / 8.4 / 9.9 / 14.0 / 13.3
Actual NPLs as share of total loans in 1998
JP Morgan / 11.0 / 17.5 / 7.5 / 5.5 / 17.5
Goldman Sachs / 9.0 / 14.0 / 6.0 / 3.0 / 18.0
Source: BIS (1998)
Some Asian governments played in role in all this by acting as a cheerleader to poorly-judged lending. Prudential supervision was inadequate in many countries. Implicit government guarantees of bailouts also altered the risk-reward payoff for lenders. More egregious was how governments directed loans to politically-favored companies. In Korea, the myth of chaebols being daema bulsa (too big to fail) was inspired by the government’s frequent rescue of the insolvent conglomerates. This encouraged banks to continue lending to chaebols.
Governments also encouraged the buildup of excessive short-term external debtthrough currency pegs and capital inflow sterilization (Table 2.0 reveals the external debt taken on by selected Asian economies).[22] Sterilizing inflows raised interest rates domestically, while the currencies were fixed at a rate higher than the market equilibrium. The interest differential and seemingly durable currency pegencouraged domestic banks to borrow abroad to lend locally. These policies encouraged domestic financial institutions to load up on foreign debt.
Table 2.0: External DebtIndonesia / Korea / Malaysia / Philippines / Thailand
1996 / 1997 / 1996 / 1997 / 1996 / 1997 / 1996 / 1997 / 1996 / 1997
Short-term external debt (as percentage of GDP) / 14.3 / 15.9 / 13.5 / 11.1 / 11.2 / 15.1 / 9.5 / 14.1 / 20.3 / 18.8
Short-term external debt (in billions of dollars) / 32.2 / 36.0 / 100 / 68.4 / 11.1 / 14.9 / 8.0 / 11.8 / 37.6 / 34.8
Source: World Bank and IMF (1999)
The Ghost of Crisis Yet to Come
Perhaps the most optimistic indicator for Asia was how despite official disagreements over the causes of the Asian Financial Crisis, governments stillundertookmany essential reforms crucial to recovery. The main takeaways from the Crisis must broadly address three areas:prevent future crises, prepare economies to better manage crises, and minimizethe short-term damage from crises.
1. Prevent Future Crises
One cause for the Crisis laid in the unrestrained growth in credit due to misaligned incentives for leverage and foreign borrowing. Proper incentives must be erected to reduce excessive leverage and foreign borrowing. This must be achieved through corporate sector reform, as the sector was the ultimate end point for much of the foreign borrowings. Stronger corporate governance and better information disclosure reduces the possibility of another Hyundai or Daewoo in Asia - huge Korean conglomerates that hid their insolvency behind lax accounting rules and excessive borrowing.
The financial sector, like the corporate sector, also shares culpability for the Crisis. There is a need for Asian governments to ensure more prudent risk management by the financial sector. The regulatory frameworks within which financial institutions operate have to be aggressively strengthened. The financial sector also needs to be more transparent. For example, NPL ratios up to the Crisis severely understated the number of NPLs from these institutions. Limited deposit insurance could also prevent some of the bank runs seen in Asian countries during the Crisis.